In part one of this series, I suggested that the parties to a deal should not just settle for the trailing twelve month (TTM) average in calculating target working capital. In part two, I gave my perspective on working capital and purchase price. In part three, I discussed how the parties should define working capital in the purchase agreement and how various disputes should be handled. In this final post, I will discuss rollover equity and how to consider cash in drafting the working capital provision.
To this point in the series, I have been considering the most common situation where a buyer acquires 100% of the business being sold. In this situation, if there is a working capital true-up payment to be made, the buyer pays the seller, or the seller pays the buyer. In a stock purchase transaction where the sellers will maintain an equity ownership in the company being sold, the parties should reconsider who makes the payment to whom. This will often be the case where a private equity firm buys from the founding shareholders. In this situation, it makes more sense for the company to pay the sellers if too much working capital is left in the business and for the sellers to pay the company if they don’t leave enough working capital in the business.
Let’s first consider a working capital shortfall. Again, the underlying premise is that the working capital to be left in the business should be the amount of working capital necessary to continue to operate the business post-closing without the infusion of outside capital. If there is a working capital shortfall, by definition then, the business needs an infusion of capital. This infusion is accomplished by the sellers paying into the company the amount of the shortfall. Then, the company has the appropriate amount of working capital. What I typically see, however, is the standard provision that any shortfall in working capital is paid by the sellers to the buyer. This outcome has at least two flaws.
First, the company still does not have adequate working capital to operate the business without the infusion of outside capital. Second, had the sellers left adequate working capital in the business, they would have owned some percentage of that working capital equal to the amount of equity they rolled over. If the seller pays the amount of the shortfall directly to buyer and not into the company, the buyer owns 100% of that amount and the seller owns zero.
The converse is true with a working capital excess. In this situation, the sellers have left more working capital in the business than is necessary for the daily operations of the business. Thus, they have not distributed to themselves these excess funds as a return on their investment in the business. In this situation, therefor, the company should distribute out this excess to the sellers. The buyer should not be paying additional purchase price. If the buyer pays to the sellers the amount of this excess, the sellers are receiving 100% of the excess and would also enjoy a percentage of the excess working capital equal to the amount of equity they rolled over. In other words the sellers would receive more than 100 cents on the dollar for each dollar of excess working capital.
The same analysis holds true for each component of purchase price. If there is indebtedness or transaction expenses that are not paid at closing, the sellers should pay that amount into the company so the company can pay it off. The sellers should not pay those amounts to the buyer, in particular because the company then doesn’t have the cash to pay off these amounts. If there is excess cash in the business, the company should pay that cash out to the sellers, not the buyer to the sellers. And because this analysis applies to each component of purchase price, when you net all these amounts together—working capital excess/shortfall, excess or shortfall of cash, or overpaid or underpaid debt or selling expenses—that too should either be paid by sellers to the company or the company to sellers. The buyer should have no part in these payments.
Cash as Part of Working Capital
The parties in most, if not all, transactions characterize the purchase price to be paid for a business as being paid on “debt free, cash free basis.” In other words, any indebtedness of the company being acquired needs to be paid off out of the purchase price. Similarly, the buyer doesn’t want to pay cash for cash, so the purchase price assumes the sellers will sweep the cash out of the business, and working capital will be adjusted to remove cash as a current asset. With respect to debt and transaction expenses, this all makes sense. When it comes to cash, however, the logic seems to break down.
Returning once again to the underlying premise of this series of posts—the working capital to be left in the business should be the amount of working capital necessary to continue to operate the business post-closing without the infusion of outside capital—adjusting either the target working capital or actual working capital to remove cash makes little sense. As discussed, however, target working capital is almost always set as the TTM average of the working capital of the business, adjusting out certain items, including cash. Sometimes, cash is a very large component of the working capital of the business. The parties should not categorically exclude cash to arrive at a simple TTM average calculation and ignore the actual working capital necessary to operate the business post close. Rather, the parties should examine the business’s operating cash needs and determine what is excess cash. Also, in all likelihood, the business needs actual cash to operate and cannot wait to liquidate inventory or accounts receivable.
If the parties to a transaction arrive at the target working capital by determining the proper amount of working capital to operate the business without outside capital, cash should be taken into account in arriving at working capital. If there is excess working capital, then the excess cash can be paid directly by the buyer to seller or as a return of capital to seller out of the cash of the business. And, if the sellers have rollover equity, as discussed above, the payment should certainly be made out of the company’s cash, not the buyer’s cash. Then, the company is left with the proper amount of working capital to operate the business post-closing.
I know many of the ideas expressed in this series of posts present a novel way to reconsider working capital in transactions. As with many provisions in today’s purchase agreements, I don’t know why the practice has evolved on working capital the way it has. I submit that transaction professionals take a fresh look at working capital and the purpose it serves and start drafting these provisions to serve that purpose.